Infrastructure creation will eventually improve supply efficiencies and reduce prices

There is a growing argument for interest rate cuts in India. Industry points to abysmal growth numbers and the comfort of lower inflation in recent times — thanks to the slump in international energy, food and commodity prices.

Just a few months ago, the monetarist argument for further rate hikes was more audible. There were serious doubts about achieving the Urjit Patel Committee-set CPI target of 6% by January 2016. Monetarists, of course, believe that acrossthe-board rate hikes can quell CPI inflation in India.

One fear is that we are condemned to swinging between these two opposite viewpoints periodically, hostage to the flavour of economic data that emerges. Or perhaps we are condemned to waiting endlessly for data reiteration, to ensure that any given trend is medium rather than short term.

Are there merits to both viewpoints?

Impossible as it sounds, perhaps there is a meeting ground to both, which doesn’t necessarily depend upon the immediate future price of oil and commodities or the future actions of other global central banks.

Across-the-board rate cuts will give immediate relief to industry and consumers. But it is also possible to envisage a situation where lower interest rates lead to sharply higher consumption, in excess of the growth in investment. This could lead to asset bubbles, increase in gold demand, twin deficits and market instability. At a time when consumption levels are very low, this could sound like scare-mongering. However, we have seen this happen before. Combine feel-good sentiment, buoyant asset markets with low interest rates, and we could see this scenario play out quite rapidly.

At the other end of the spectrum, rate hikes had a critical role to play in stabilising the rupee late last year and early this year. However, rate hikes did not help the supply side cause. High interest rates meant higher input costs to producers and a disincentive to fresh investments — over and above the serious policy side issues that led to a large number of stalled infrastructure projects.

Eventually, besides the serendipity of low global energy, food and commodity prices, there is merit in the argument that supply side measures, helped by successful infrastructure investments, are perhaps best placed to sustainably address India’s inflation issue.

Where is the meeting ground? Perhaps what we need now is directed monetary policy. India needs a prolonged period where infrastructure investments are incentivised, strongly, over excessive consumption.

If money is directed towards the creation of roads, power, ports and so on, it can be given practically free of interest cost. After all, this infrastructure creation will eventually improve supply efficiencies and reduce prices. Alongside, these infrastructure investments are also an essential prerequisite to kickstart manufacturing, increase employment, and realise the ‘Make in India’ aspiration. Infrastructure is likely the panacea to stable macroeconomics in India over the next few years.

On the other hand, if the money is going towards financing of consumption or asset purchases, particularly imported items (such as gold), interest cost needs to be calibrated and high. Excessive growth in consumption and asset purchases, faster than the growth in infrastructure and capacity creation, can lead to financial instability.

So what would I like to see in the RBI monetary policy?

To start with, the monetary policy debate needs to move away from across-the-board interest rates, and look separately at consumption and investment trends.

Perhaps we should think of serious incentives and provision of cheap liquidity for fresh infrastructure lending. Incremental infra lending by banks can be refinanced by the RBI at cheap rates. Incremental infra lending can be given priority sector lending status. A part of the liquidity generated by foreign currency inflows can be directed solely towards fresh infrastructure investments. As a corollary, the implied interest rates in the foreign exchange markets could be kept low as well, to encourage less open foreign exchange liabilities.

Alongside, we could look at measures that strongly dissuade excessive consumption and asset purchases. Rates can remain kept high for all such banking assets. Risk weights for all consumption based lending by banks can be calibrated accordingly.

With this approach of a directed policy, in the medium run, we could perhaps be agnostic to the nature of short-term external and domestic data flow. We could have applied this approach a year ago, and perhaps we could continue this approach a year hence.

This approach has been suggested before. A year back, when inflation was high, academics and monetarists shunned it, suggesting it is inelegant. Now, with inflation dramatically lower, industry will probably find this approach to be a poor compromise to their demand for dramatically lower across-the-board rates. If diametrically opposite sides find equal fault with a proposal, perhaps there is some merit to it.

China and Japan have exactly the reverse problem — they do not need further investment, and instead require consumption to utilise all the capacity created over the years. At least from our perspective, that seems like a nicer problem to have. Hopefully, we will grow into them over the next two decades.

(The writer is regional head of financial markets, South Asia, Standard Chartered Bank)